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Gold and the Interest-Rate Dis-Connect

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I don’t like to make short-term predictions about the price of gold – people who do are usually very lucky or very wrong.

But times they are changing . . . and we are entering a new phase in gold-price action where expectations of Fed interest-rate policy will become less important and other, more bullish, gold-price drivers come to the fore.

Just look at the past few weeks or even, for that matter, the past year: The day-to-day, week-to-week, fluctuations in the price of gold have been almost entirely a reflection of the gold-market’s expectations of prospective Federal Reserve interest-rate policy.

More fundamentally, news of an improving economy triggered expectations that the Fed would raise interest rates by 25-basis points at its September Federal Open Market Committee meeting . . . and expectations of higher interest rates, even a meager quarter-percent rise, predictably brought gold prices down.  In the event, the Fed opted keep rates virtually unchanged — but signaled a possible quarter-point increase at their December FOMC policy-setting meeting.

Meanwhile, news of an economy struggling to maintain any upward momentum has had the opposite effect: Expectations that the Fed would dare not tighten by raising rates supported yet another rally in the price of gold.

But, to my mind, this way of thinking about gold-price prospects is naïve. Indeed, the belief that a 25-basis point hike in the Fed funds rate, the key policy instrument of the central bank, would send gold prices sharply lower makes no sense.

At the risk of oversimplifying, prices of other financial instruments, financial instruments that also compete with gold, fluctuate far more than a quarter-percentage point, not just from day-to-day but even intra-day!

Moreover, large-scale fund managers, institutional speculators, central-bank reserve managers, even retail investors buy and sell gold with expectations that prices are going to go up or down much more than suggested by a meager 25-basis points – or even several percentage points – in a fairly short time span.

Importantly, they also buy and hold gold for a variety of reasons, reasons that cannot be easily quantified in a small rise or fall in interest rates, reasons such as portfolio diversification, financial insurance, inflation protection, hedging stock-market risk, etc.

Most important, much of the world’s gold trading and purchases — whether for investment, reserve diversification, jewelry, cultural or religious practices — takes place in China, India, and other Asian countries.  Indeed,  participation from this region is hardly governed by U.S. monetary-policy considerations.

But, whatever the news in the weeks and months ahead, I believe the Fed will have little room to raise interest rates by anything more than a token increase, if that. What’s more likely, the U.S. and global economic news will continue to disappoint – and this could be enough to support a rising gold price.

Another near-term catalyst could very well be seasonal buying from both India and China, the world’s two-biggest gold-buying nations. Gold demand in India has a strong seasonal component, reflecting the annual monsoons, the associated rise in agrarian incomes, and the autumnal festivals beginning in the September-October period.

Gold demand in China also typically picks up late in the year in anticipation of the Lunar New Year holiday occurring this year in January 2017. In addition, once it is clear we are in a rising market, Chinese gold buyers are likely to chase the market higher, fearful of missing out on still-attractive prices.